Can I learn to love this small-cap palm oil stock?

M P Evans is a fast growing small-cap stock with plenty of potential. But James McCombie thinks it has a cloud hanging over it.

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M. P. Evans (LSE: MPE) is a small-cap stock that has caught my eye for a lot of good reasons. This £456m market capitalisation company has been growing its revenues by 27% annually on average over the last five years. Its average operating margin of 24% is impressive. Cash flow and earnings on a per-share basis grew at 33% and 44% on average each year for half a decade.

The company continues to impress with its balance sheet. Liquidity looks great as current assets are at least twice what current liabilities are. A debt-to-equity ratio of 0.35 means low leverage. So far so good. But the business that M. P. Evans is in makes me pause for thought.

Problematic palm oil production

In 2015 I was in Penang, Malaysia. The air was hazy and smelt of smoke. This smog had drifted across the sea from Indonesia where forests were burning. The World Resources Institute suggests most of the fires are human-caused and linked to the agriculture industry, particularly palm oil, of which Indonesia is the world’s largest exporter.

M. P. Evans is a producer of Indonesian palm oil. It does, however, make a case that it does this sustainably. All the palm oil produced from company-owned estates is certified sustainable according to the Roundtable for Sustainable Palm Oil’s standards. The same is true for managed smallholders. But the company also accepts oil palm fruit from non-verified independent growers for its mills. As of 2020, the date of the last standalone sustainability report, 27% of the total production could not be confirmed as sustainable.

The plan is to increase that number to 100% by sometime next year. That would be reassuring. But why accept unverified products at all? Why not only take from smallholders where the company is satisfied they produce sustainably? Well, because the company can process significantly more oil-palm fruit than it and its verified smallholders can grow.

Small-cap stock watchlist

M. P. Evans is also currently exiting its property development operations in Malaysia. It disposed of 70 hectares of land from a wholly owned subsidiary to a joint venture in 2021. It still has 200 hectares left. I am likely being cynical, but this arrangement does suggest there is scope to sell off parcels when group earnings are not expected to meet forecasts. However, I like M. P. Evans’s plan to focus on one thing: palm oil.

Palm oil is the world’s most popular and most traded vegetable oil. Demand for it has increased by 7% each year since 1990. According to one report, about half the products in UK supermarkets contain palm oil. It appears to be a decent business to be in. And the company’s operating numbers support this.

However, it’s worth pointing out that the company’s operating margins tend to dip when the average annual price of crude palm oil falls and rise when it rises. That’s because it is a price taker in a commodity market.

All things considered, although M. P. Evans is now deservedly on my watch list, it won’t end up in my Stocks and Shares ISA just yet. The next standalone sustainability report is due soon. I would like to see what progress has been made on this front and see how I feel about this small-cap stock then.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James McCombie has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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